Wednesday, April 23, 2014

The California Court of Appeal, Fourth District, recently applied equitable subrogation to allow one bank's deed of trust to take priority over a trust deed previously recorded by another lender, thus placing the two lenders in the same priority positions they had anticipated and intended at the time they made their respective loans to the borrowers.

Borrowers owned a residence subject to first and second deeds of trust that secured loans totaling over $3 million. Borrowers subsequently paid off the two loans with a refinancing loan from a bank ("First Bank").

Based on a preliminary title report showing the first and second deeds of trust, First Bank had expressly instructed its escrow company to disburse funds only to pay off the existing first and second deeds of trust, that the refinancing loan was to be secured by a new first deed of trust, and that any second mortgage on the property was to be subordinate to First Bank's deed of trust. First Bank filed its first deed of trust the same day the loan funds were disbursed.

Unbeknownst to First Bank, however, one of the Borrowers had earlier obtained a loan for over $2 million from another bank ("Second Bank") to fund a medical practice. That loan was guaranteed by Borrowers and secured by the same property. Aware that Borrowers' residence was already subject to the first and second trust deeds, Second Bank secured its loan against personal property of the medical practice and with a third deed of trust against Borrowers' residence. Second Bank filed its deed of trust against the property roughly two months before First Bank closed on the refinancing loan.

The loan for the medical practice later went into default and Second Bank thus instituted judicial foreclosure proceedings against the residence. First Bank filed a cross-complaint seeking an equitable lien on the property and declaratory relief, and moved for summary adjudication.

The lower court granted First Bank's motion, establishing two equitable liens in favor of First Bank for the amounts paid toward the first and second deeds of trust. Second Bank appealed.The appellate court affirmed.

Noting among other things that First Bank anticipated that it would receive a first deed of trust on the property, that its escrow instructions expressly forbade disbursement of the loan proceeds if First Bank's deed of trust would not be in a primary position, and that Second Bank anticipated that its deed of trust would be in a junior position to the first and second deeds of trust, the Court of Appeal applied equitable subrogation as an exception to California's "first in time, first in right" system of lien priorities. See Cal. Civ. Code § 2897 ("Other things being equal, different liens upon the same property have priority according to the time of their creation . . . .").

In so doing, the Appellate Court applied the longstanding rule in California allowing equitable subrogation in situations involving competing liens where a lender advanced funds to pay off a prior lien with the understanding of all parties that the intent was for the lender to obtain a first lien on the property. See Simon Newman Co. v. Fink, 206 Cal. 143, 146 (1928)("Simon")(setting forth the test for equitable subrogation, including requirements that parties intend for a lien holder to hold a superior position, that the lien holder not be "chargeable with culpable and inexcusable neglect," and that others not be prejudiced).

Also noting in part that the title report had been prepared prior to the recording of Second Bank's deed of trust, the Appellate Court ruled that First Bank was not "chargeable with culpable and inexcusable neglect" as it had no actual knowledge of Second Bank's deed of trust, breached no duty owed to Second Bank, and had not engaged in any misleading conduct.

Ruling that constructive notice does not preclude application of equitable subrogation, the Court explained, "the failure to search the records does not itself preclude subrogation . . . . neither should reliance on a preliminary title report. . . . By the same token, if the failure to make a records search does not reduce the lender's equity, neither should the lender's reliance on a preliminary title report that failed to reveal an intervening deed of trust."

Weighing the respective equities, the Appellate Court concluded that First Bank was entitled to equitable subrogation as a means to carry out the intentions of the parties. In reaching this result, the Appellate Court observed that in paying off the existing first and second deeds of trust, First Bank expected a first deed of trust in return and expressly instructed that the loan funds were not to be disbursed unless First Bank had a first deed of trust on Borrowers' property. In addition, the Appellate Court again pointed out that First Bank did not know of Second Bank's loan and deed of trust, and that Second Bank knew of the first and second deeds of trust and, as anticipated, received a third deed of trust for its loan to the medical practice.

Rejecting Second Bank's argument that equitable subrogation in this case was prejudicial and punishing, the Appellate Court ruled that equitable subrogation provided Second Bank with exactly what it had bargained for: a deed of trust third in priority and thus in the same position it would have held if Borrowers had not paid off their first and second deeds of trust with the refinancing loan.

The Appellate Court also stated that the fact that First Bank may have a cause of action against the title insurance company for failing to conduct a subsequent records search closer to the date of the refinancing loan did not change the equities in this case.

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